China's Devaluation: Simply Part of a Global Currency War?

China’s surprise decision to stop supporting its currency marks the latest move in the dangerous game of competitive currency devaluations that has been underway since the 2008 financial crisis. All of the major industrial nations have been forced to use zero interest rates and currency depreciation as a response to weak growth and deflation in commodity prices. But there is no positive outcome possible in a zero-sum process of competitive currency devaluations.

The immediate cause of the move by Beijing is political and illustrates the concerns of China’s leaders that a slowing economy will result in social instability. But it is important to recognize that the bubble in real estate and financial assets that resulted in the 2008 market crash was fueled by capital inflows to the United States and Europe from China, which sought to recycle its vast trade surplus with the west by investing in financial and real assets. The fact that this surplus was funded via the creation of trillions of dollars in debt only made the situation more unstable.

With the collapse of the West’s appetite for Chinese exports, Beijing has gone through several attempts to “rebalance” its economy to focus on internal demand rather than exports. As we noted earlier in The National Interest (The False Hope of Chinese Economic Rebalancing), the loss of export markets in the West has put the Chinese economy into a deflationary tailspin that is impacting the entire world economy. Falling prices for oil, copper and other key industrial commodities, and the related decrease in economic activity, are a direct result of the financial deflation since 2008.

Dr. David Woo of Merrill Lynch believes that the move by China to weaken its currency isjust the start of a series of efforts by Beijing’s communist rulers to avoid an economic crisis. Financial bubbles in the housing sector as well as stocks have forced the government to take action to prevent these speculative anomalies from collapsing. But with the export sector weak—in part due to the Chinese currency being effectively pegged to a strong dollar—and few practical alternatives to support employment and the growth of consumption, China’s authoritarian rulers face their greatest fear: namely economic stagnation.

James Rickards, author of Currency Wars and one of America’s most astute observers of China, believes that the endgame in this latest chapter of beggar thy neighbor could be a global economic crisis:

After a truce in the currency wars between China and the U.S., China has broken the peace with its shock devaluation over the course of August 11-12. Investors should expect further devaluation, not only from China, but all of the emerging markets and developed economies such as Canada and Australia. The dynamic is clear - currency wars have no logical conclusion except for systemic reform or systemic collapse. Right now, the latter seems more likely. Until then, the war will go on.

For months financial markets have been fixated by the idea that tiny Greece might need to exit the European Union and devalue its currency. Now seeing China do so is a shock for markets and policy makers alike. Not only does it call into question the image of solidity and growth in China, but it also begs the question as to whether seven years of low interest rate policies in the United States and EU have done anything more than temporarily slow the relentless advance of deflation. Was the growth in China (and other nations) over the past ten or twenty years an illusion, funded with debt incurred by the western nations? Do the bubbles in housing and financial assets in China represent a crisis in the making, a final climactic event before an inevitable adjustment to reality?

It is difficult for western observers to appreciate that the claims of economic growth made by China’s rulers have never been believable—this because political stability is the dominant consideration. Even experienced China hands with great resources in the region fall into the cognitive illusion of thinking that the economy of China is comparable to the market economies of the west. But with all that said, the reaction in foreign financial markets to China’s devaluation is probably overblown.

Just a few weeks ago, China Beige Book, one of the best sources of information on the country available in the west, stated in a report entitled China’s Economy is Recovering: